Russian economy worsens even before sanctions hit

Wednesday

Apr 16, 2014 at 10:00 PM

By David M. Herszenhorn THE NEW YORK TIMES

MOSCOW — Margarita R. Zobnina, a professor of marketing here, has been watching the Russian economy's gathering woes with mounting alarm: friends who have moved abroad with no plans to return; others who have put off business ventures because of rising uncertainty. Meanwhile, Zobnina and her husband, Alexander, also a professor, have rented a safe-deposit box to hold foreign cash as a hedge against the declining ruble.

Most shocking, she says, is that her local grocery is now selling anchovies packed in sunflower oil rather than olive oil, an obvious response to the soaring cost of imports.

"That really freaks me out," she said.

While the annexation of Crimea has rocketed President Vladimir Putin's approval rating to more than 80 percent, it has also contributed to a sobering downturn in Russia's economy that appears to be worsening even before Western sanctions take full effect. With inflation rising, growth stagnating, the ruble and stock market plunging and billions in capital fleeing the country for safety, the economy is teetering on the edge of recession, as the country's minister of economic development acknowledged Wednesday.

Putin, who just lavished $50 billion on the Sochi Olympics, also must absorb the costs of integrating Crimea, which economists and other experts say has its own sickly economy and expensive infrastructure needs. The economic costs have been masked by recent patriotic fervor but could soon haunt the Kremlin, as prices rise, wages stall and consumer confidence erodes.

Even before the Crimean episode and the resulting imposition of sanctions by the West, Russia's $2 trillion economy was suffering from stagflation, that toxic mix of stagnant growth and high inflation typically accompanied by a spike in unemployment. In Russia, joblessness remains low but only because years of population decline have produced a shrunken, inadequate labor force.

In recent weeks, international and Russian banks have slashed their growth projections for 2014, with the World Bank saying the economy could shrink by 1.8 percent if the West imposes more sanctions over Ukraine. By some accounts, more than $70 billion in capital has fled the country so far this year, and the main stock market index fell by 10 percent in March — and a dizzying 3 percent just on Tuesday, over fears of greater Russian involvement in Ukraine.

"This is our fee of sorts for conducting an independent foreign policy," Aleksei L. Kudrin, a former Russian finance minister, said at a recent investor conference in Moscow. He added that the sanctions and the fallout from Putin's foreign policy moves would drain hundreds of billions of dollars from the national economy and strangle growth for the remainder of the year.

But Kudrin, who quit his post in a dispute over the Kremlin's economic policies, said the population had yet to confront the full bill, which he predicted would grow as a result of the steep costs of absorbing Crimea, a geographically isolated peninsula.

"Society has not yet seen the final result, and that will be when this puts the brakes on real incomes," he said. "For now, society accepts this fee."

From a textbook perspective, the deep-rooted ills in Russia's economy have been clear for years: The decadelong skyrocketing in energy prices that buoyed Putin's popularity has flat-lined, exposing the country's dangerous over-reliance on revenues from oil and natural gas. Efforts to diversify into manufacturing, high technology and other sectors have failed, and officials have been unable, or unwilling, to stop the rampant, corrosive corruption that scares off foreign investors.

Consumer demand, which had been a primary driver of the Russian economy in recent years, stalled in 2013. Surveys by the Levada Center, Russia's only independent polling institute, show that consumer sentiment has been on a slow, steady decline since 2010, while fears of inflation — especially rising prices for basic necessities, which have persisted since the 1990s — have grown along with new anxiety about a potential drop in wages or rising unemployment.

"If you want to open your eyes, you would admit that it is a slow, downward trend of social optimism and consumer optimism," said Marina Krasilnikova, who leads income and consumer research for the Levada Center.

"The situation with Ukraine and Crimea has resulted in patriotic and imperialistic optimism," Krasilnikova said.

But, she added, "this optimism will not last long."

Some analysts said that Russia's annexation of Crimea had proved that Putin puts politics ahead of reasonable economic decisions and that there was little reason for economic optimism, particularly given his inward, xenophobic turn, including his vow to create Russia's own cashless pay systems and even its own credit rating agency so it would not have to rely on the global financial system.

Miljenko Horvat, a private equity investor who ran Citibank's office in Russia in the 1990s, said that Russia had simply failed to make itself economically relevant beyond its energy supplies.

Horvat, who now lives in Vancouver, said that he often challenged his Russian friends by making the following point: "I wake up in the morning and drink coffee from a machine made by a Swiss company, Nescafé. I wear something that was designed in France or Italy but probably made in Turkey. I get into a German car, look at a Korean phone, use a computer that was designed in California but made in Japan or Korea. Russia just doesn't touch me in my daily life. It just doesn't matter. It's just not relevant. So where is the economic engine going to come from?"

Horvat said that he had lived in Russia through defaults in 1991, 1993 and 1998 and that he expected another one.

"I am not long in Russia," he said, invoking the financial term for betting on a rising stock, "neither in my portfolio, nor in life."

Given the recent turmoil, a catastrophe has been averted so far largely because the price of oil has remained stubbornly high, at nearly $110 per barrel of Brent crude Wednesday,.